a. You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected return for the following stocks, and plot them on an SML graph. StockBetaE(Ri)U0.85 N1.25 D-0.2 b. You ask a stockbroker what the firm's research department expects for these three stocks. The broker responds with the following information:StockCurrent PriceExpected PriceExpected DividendU22240.75 N48512 D37401.25 Plot your estimated returns on the graph from part (a) and indicate what actions you would take with regard to these stocks. Explain your decisions.

Question
Asked Mar 22, 2019
947 views
a. You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected return for the following stocks, and plot them on an SML graph. 
Stock Beta E(Ri)
U 0.85  
N 1.25  
D -0.2  
b. You ask a stockbroker what the firm's research department expects for these three stocks. The broker responds with the following information:
Stock Current Price Expected Price Expected Dividend
U 22 24 0.75  
N 48 51 2  
D 37 40 1.25  
Plot your estimated returns on the graph from part (a) and indicate what actions you would take with regard to these stocks. Explain your decisions. 
check_circle

Expert Answer

Step 1

Part (a)

RFR = 10%

The market return, RM =  14%

The expected return for a stock using CAPM equation is: E (Ri) = RFR + Beta x (RM - RFR)

Please see the table below for E(Ri) of three stocks:

Stock

Beta

E(Ri) = RFR + Beta x (RM - RFR)

U

0.85

13.40%

N

1.25

15.00%

D

-0.2

9.20%

Plot on the SML is shown in the drawing on the white board.

fullscreen
Step 2

Part (b)

Expected return as per research house = (Expected price + Expected dividend - Current price) / Current Price

  • If expected return as per research house, ER > E(Ri) calculated in part (a) then the stock is undervalued and we should buy the stock.
  • If expected return as per research house, ER < E(Ri) calculated in part (a) then the stock is overvalued and we should sell the stock.

Please see the table below:

Stock

Current Price

Expected Price

Expected Dividend

Expected return as per research house

E (Ri) as calculated in part (a)

Decision

Action

 

CP

EP

ED

ER = (EP + ED - CP) / CP

   

U

22

24

0.75

12.5%

13.4%

Overvalued

Sell

N

48

51

2

10.4%

15.0%

Overvalued

Sell

D

37

40

1.25

11.5%

9.2%

Undervalued

Buy

The plot is shown on the white board. U* represents the expected return as per the research house for stock U and so on....

...

Want to see the full answer?

See Solution

Check out a sample Q&A here.

Want to see this answer and more?

Solutions are written by subject experts who are available 24/7. Questions are typically answered within 1 hour.*

See Solution
*Response times may vary by subject and question.
Tagged in

Business

Finance

Related Finance Q&A

Find answers to questions asked by student like you

Show more Q&A add
question_answer

Q: Here are some historical data on the risk characteristics of Ford and Harley Davidson. Harley Davids...

A: Since you have asked a question with five sub parts, I will address the first three sub parts. Pleas...

question_answer

Q: Finding the Interest Rate: Concept Connection Example 6-3 (page 237) 18. What interest rates are imp...

A: Interest rate:An interest rate is a percentage on the principal amount at which a lender gives money...

question_answer

Q: A) Use the appropriate formula to find the value of the annuity. B) Find the interest. Periodic ...

A: Part (a)If an annuity A is paid at the end of period over N periods and bears a discount (interest) ...

question_answer

Q: Use the following information: . Debt: $79,000,000 book value outstanding. The debt is trading at 94...

A: Calculation of Total Market Value:

question_answer

Q: A bond with a coupon rate of 7.30% has a price that today equals $868.92. The $1,000 face value bond...

A: Calculation of Yield to Maturity of the Bond:

question_answer

Q: The following numbers were randomly generated from a standard normal distribution: -0.25    0.3     ...

A: The formula for simulated price,S based on the initial closing price of S0 will be given by the equa...

question_answer

Q: Your client is currently 19 years old. Your client wishes to retire at age 71. Your client's expecte...

A: Two assumptions are required to be made because the question is silent about them:All cash flows i.e...

question_answer

Q: What finances do you need to have to achieve getting somewhere with Cosmetology?  For instance to bu...

A: Some essential costs that are needed to be assessed before building a salon are:Cosmetics: A salon h...

question_answer

Q: Ed Draycutt is the engineering manager of Airway Technologies, a firm that makes computer systems fo...

A:   Evaluate Ed’s analysis. Does Ed have the right expected NPV? What’s wrong with his analysis? Ed ha...